Europe's Catalogue of Unforced Errors

As I write, Europe's leaders are still meeting in Brussels, wrestling for the nth time with a debt-restructuring scheme for Greece and, much more important, a plan to address the wider European sovereign-debt crisis. It is important to understand that these are very different issues.

If the Greek state is insolvent (admittedly, not everybody thinks it is), then dealing with its debts is a question of apportioning unavoidable losses among creditors and taxpayers (domestic and EU-wide). Obviously, in political terms, that is an extremely difficult task. But states such as Italy and Spain, to say nothing of EU governments as a group, are plainly solvent (for now). In their case, the question of apportioning losses need not arise if the crisis of confidence can be arrested--and it could be, rather easily, if only EU governments would stop deluding themselves.

The [EU leaders'] summit follows a vote in the German parliament, which approved further changes to the role of the European Financial Stability Facility, the euro zone's rescue fund, but sought to limit the European Central Bank's role in bailout policies, including ending its purchases of euro-zone bonds of troubled member nations once the EFSF is in place.

German Chancellor Angela Merkel said in an address to the parliament that governments must ensure that the debt crisis doesn't spread from Greece to other countries.

Interesting, because limiting the role of the ECB as a buyer of eurozone bonds is a good way to ensure that the crisis does spread from Greece to other countries.

It is useful to start by describing the weakness of government bond markets in a monetary union.

• Eurozone governments issue debt in a "foreign" currency, ie one which they do not control by fiat.

• Thus governments cannot guarantee to the bondholders that they will always have the necessary liquidity to pay off the bond at maturity.

This contrasts with "stand-alone" countries that issue sovereign bonds in their own currencies. This feature allows these countries to guarantee that the cash will always be available to pay out the bondholders. This is why a stand-alone country can provide an implicit guarantee--the central bank is a lender of last resort in the government bond market.

The absence of such a guarantee makes the sovereign bond markets in a monetary union prone to liquidity crises and contagion--very much like banking systems were before central banks backstopped them as lenders of last resort...

With their unlimited firing power, central banks are the only institutions capable of stabilising the financial system in times of crisis.

The result of this failure of the ECB to be a lender of last resort has been that a surrogate institution, the EFSF/ESM, had to be created that everybody knows will be ineffective. It has insufficient firepower and has an unworkable governance structure where each country keeps its veto power. In times of crisis it will be paralysed. As markets know this, its credibility will be weak.

To hide these shortcomings European leaders are now creating the fiction that by some clever leveraging trick the resources of the EFSF/ESM can be multiplied, allowing the ECB to retire to its Panglossian garden of inflation targeting. European leaders should know, however, that leverage creates risk, very large risks. These appear with full force when liquidity crises erupt. Thus when the leverage trick will be most needed, it will fail as it will show how risky the positions are of those who have guaranteed the leverage construction. Governments which now enjoy AAA creditworthiness will take the full blow of a 100% loss on their equity tranches and will lose their creditworthiness in one blow. The whole risky construction will collapse like other clever financial constructions of the recent past.

Academics have the reputation of living in an ivory tower far away from the realities of the world. My impression is that instead of the academics, it is the European leaders who have been living in an ivory tower. Disconnected from the economic and financial realities, they have created an institution that does not work and will never do so properly. Now they are creating a financial gimmick that, in their fantasies, they expect to solve the funding problems of major Eurozone countries.